Succession Planning: Importance of Incentive & Retention Plans

No matter how you slice it, One of the first questions a business broker or potential buyer will ask when inquiring about buying your business is “Who are the ‘key’ employees and what is their incentive to stay?”incentive/retention plans are critical to succession planning in your business. In order to maximize the sale price, it is critical to have a capable, motivated, and loyal group of key employees. If you are instead contemplating an inside sale to a family or non-family member, you are stuck with the dilemma of how to finance the sale transaction. You may not know that there are several options to aid in financing your exit through incentive/retention plans.

Every well-designed plan should have four key parts:

Financial or Performance Benchmarks: At least one benchmark should be achieved in order to trigger an award. Examples include: percent of profit over a minimum, percent increase in profit, number of new or returning customers, etc. The benchmark needs to be clear and easy to calculate.

Significant Reward Potential: In order to motivate, the award should be substantial for the employee(s). According to Maxim Consulting Group, variable compensation should be at least one month’s pay and up 25% of the employee’s base pay.

Deferred Benefit Payout: To build in a retention component, some, if not all, of the benefit should be deferred to a later date. It is my recommendation that at least 60% of the benefit should be deferred. However, deferral percentages, time period of payouts, and vesting schedules must be balanced by the owner between retention and motivation.

Clear and Simple Communication: The plan needs to be written and communicated thoroughly with each plan participant.

Types of Plans

As I wrote in my post, When Offering Ownership to an Employee Can Go Terribly Wrong, it is essential to be aware of the potential dangers of choosing the wrong employee or method to award stock or ownership. This is especially significant when identifying what type of retention plan is right for your company. Each type of plan has different advantages and tax implications, and may or may not be stock-based.

Stock-based vs. Cash-based

The first step is to determine whether your plan should be stock-based or cash-based. You must determine if the plan participants are going to be your business partners (Stock) or if you are just looking to just incentivize and motivate them (Cash).

Cash-based plans are more widely used in small to mid-sized businesses. Examples include non-qualified deferred compensation plans (NDCP) and Phantom stock plans. Non-qualified deferred compensation plans, like a supplemental executive retirement plan (SERP), is a plan for key employees that provides benefits above and beyond those covered in other retirement plans. They aim to provide supplemental retirement income or a means to purchase ownership shares at a time in the future. For successors, the plan can be tailored to meet their specific needs and the benefits accrue to them without any current tax consequence.

Phantom stock mimics real stock in hypothetical units (hence the spectral name) which are given to an employee as a way to encourage tenure and motivate them without handing over actual ownership. Since this cash-based plan increases or decreases with actual stock value, the employee is motivated to increase the company’s financial success which, in turn, directly links to their own earnings. Phantom Stock plans have many options for payout and could be set up to vest immediately if used to purchase ownership shares.

If you are exploring the use of a stock-based incentive/retention plan as a means to transfer business ownership to employees, I highly recommend getting advice from a professional to ensure that a stock-based plan is the best course for your business and to help you evaluate if the employee(s) are truly cut out for ownership.

Conclusion

Incentive/Retention plans are especially critical as you consider your succession planning options. Since they allow companies to invest in wealth accumulation for key employees for retention and/or to purchase shares from ownership, they are a necessity for most small to medium sized companies. Whether you intend to sell your business to a 3rd party or to a key employee, now is the time to look into developing the right plan for your employees and for your future.

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